Can Hiking The Max Tax Save Social Security?

September 10, 1998

A new idea is in the air: raising the share of earnings that is subject to Social Security FICA taxes. The idea is especially appealing to defenders of the status quo. Here, they think, is something that would help put Social Security on a sounder financial footing--and do so without raising tax rates or cutting benefit formulas.

Before the bandwagon gets rolling, it's time to face the facts. A small increase in the Social Security "max tax" wouldn't do much to reduce the system's long-term deficit. A large increase might, but only by increasing the total fiscal burden of government and by blurring Social Security's traditional focus on both fairness to individuals and protection of the needy. Does anyone really think this is the direction reform should take us?

Some Basics

Let's start with some basics. Currently, Social Security FICA taxes are levied on wages and self-employment income up to $68,400--a maximum taxable earnings base or "max tax" that is indexed each year to the growth in average wages. The earnings that fall beneath the max tax now comprise 86 percent of all earnings in employment covered by Social Security.

Many max-tax hikers propose raising this share to 90 percent, which in 1998 would require increasing the taxable earnings base to $93,600, or by more than one-third. They offer two justifications for this increase, the first of which is that 90 percent is the historical rate. This is simply incorrect. In fact, since 1937--the first year that Social Security taxes were collected--the taxable share of earnings has averaged just 84 percent.

It is true that during Social Security's first few years of operation, 92 percent of earnings were taxable. But, as former Social Security chief actuary Robert Myers explains, the max tax was subsequently allowed to lag far behind wage growth because "Congress believed...that the original base had been too high relatively." During the 1950s and 1960s, the taxable share of earnings fluctuated between 71 and 82 percent. In the 1970s, Congress passed legislation that sharply raised (and indexed) the max tax. But even so, the share of earnings beneath the cap has remained less than 90 percent in all but two years--1982 and 1983.

The second justification for increasing the taxable share of earnings to 90 percent is that, in recent years, this share has fallen unintentionally due to growing wage inequality. This argument has some merit--if you regard the share we reached in the early 1980s as optimal. Since the max tax is indexed to average wages, and since earnings at the top of the income distribution have been growing faster than average earnings, the share of all earnings that is taxable has necessarily declined.

Whatever you make of these arguments, there's a third issue. Increasing the share of earnings that is subject to FICA taxes to 90 percent would only raise enough new revenue to eliminate about one-fifth of Social Security's long-term trust-fund deficit. In other words, it wouldn't come close to solving the problem.

The Ultimate Effect

Understanding this, some max-tax hikers say justifications be damned: Let's just get rid of the cap altogether and tax 100 percent of earnings. This proposal would indeed raise a lot of revenue--roughly $70 billion in 1998, and enough over the long run, according to the Social Security Administration, to eliminate three-fifths of Social Security's trust-fund deficit. Unfortunately, it would also violate one of the public's basic assumptions about Social Security--namely, that benefits ought to represent a fair return on contributions.

Yes, the public has always accepted a progressive Social Security benefit formula that gives low earners a larger return on their contributions than high earners. But above this floor of protection, the public also expects that social adequacy will be balanced against individual equity. Until the 1980s, this balance was easy to achieve since everybody, rich and poor, reaped windfalls from a pay-as-you-go system that had not yet matured.

Today, the situation has changed. Rates of return on contributions are now dropping for all workers--and have sunk beneath the risk-free market rate for most high-earning workers. This is leading to widespread public dissatisfaction about Social Security's worsening deal. Yet eliminating the max tax would take the already mediocre returns of high earners and drive them well beneath zero. Many people would actually get back less in nominal dollars than they paid into Social Security. Imagine putting money into a bank that, instead of paying interest into your account, takes money out.

This is why so many politicians are cautious about getting rid of the max tax. Recently, at a joint Concord Coalition and AARP forum, President Clinton warned that this change would make Social Security "an actual negative investment for the people involved, where you're just taxing people's payroll far more than they'll ever get back, and they're just subsidizing the system."

Max-tax hikers might want to mitigate the equity concern by raising the taxable share of earnings to something less than 100 percent. The problem is that you would have to double the max tax to get even half the savings you could get by eliminating it altogether. To get two-thirds, you would have to triple it. In 1998, subjecting 95 percent of earnings to taxes would require jacking up the taxable earnings base to $197,400. Anyone near, at, or above this threshold would still be paying in contributions that vastly exceed benefits.

There's another problem, which has to do with the type of earnings that would be taxed. A disproportionate share of the earnings above today's max tax is not labor income. While self-employment earnings comprise only 7 percent of all covered earnings, they comprise nearly 20 percent of earnings above $100,000. Much of this income represents a return to capital invested in small businesses. Why should we apply a new tax to the profits of the successful start-up software firm--but not to the profits of the Fortune 500? In all probability, many sole proprietorships and partnerships would seek to avoid the tax by incorporating. This would be a boon for lawyers--but a deadweight loss for the economy. And it would limit the new revenue that is raised.

Finally, whatever the behavioral response, the savings would diminish over time. While higher FICA contributions would initially swell the Social Security trust funds, these contributions would eventually require that higher benefits be paid out. And even though the benefits represent a lousy return on contributions, they would still be large in absolute terms. The ultimate effect of ending the max tax would thus be to increase the cost of Social Security and the total fiscal burden of government--and all to mail six-figure monthly benefit checks to the likes of Bill Gates and Ross Perot.

A Misleading Analogy

Max-tax hikers object that theirs is not the only reform that would penalize high-earning workers. An "affluence test" on benefits would do the same.

This analogy is misleading. Yes, both reforms would move Social Security away from individual equity. But an affluence test would do so by emphasizing social adequacy more, while hiking the max tax would emphasize it less. And yes, both reforms would help bridge Social Security's long-term deficit. But an affluence test would do so by decreasing the system's long-term cost, while hiking the max tax would do so by increasing it.